Why stock index fund is your best bet

Wednesday

Nov 6, 2013 at 6:00 AM

By Peter S. Cohan, WALL & MAIN

In February, I predicted that the Dow would hit 17,000 by the end of 2013. I think I was too optimistic. But the Dow — at 15,639 on Tuesday — has risen 19.3 percent so far this year, and the investment in an S&P 500 stock index I discussed in February has gone up 24 percent so far. With the general public ignoring the stock market, I think a stock index fund remains your best bet.

As my likely inaccurate prediction shows, I am one of many (perhaps all) people who cannot predict the future of security prices. I do not even know why they move up and down. But University of Chicago professor, Eugene Fama, a 2013 winner of the Nobel Prize in economics, has a compelling theory: Stock prices reflect all available information, and therefore nobody can out-earn the market averages.

So what? If you are going to invest in a security, pick a stock index fund. As Wharton professor, Jeremy Siegel pointed out stocks earn about 7 percent annual returns over the long run. And investing in a stock index fund — a basket of securities that invests in say, all the stocks in the S&P 500 that is weighted in the same way — will let you earn those market returns. And since such funds can be managed by a computer and thus have very low fees and expenses.

Moreover, an S&P 500 index fund does not require you to pay a broker or investment advisor, who is most likely not to earn you a higher return. I think paying a financial advisor to manage your money is a legal way to tap into peoples' irrational relationship with their own money. With a little basic education you can avoid the expenses, the below-market returns, and the risk of fraud — remember Bernie Madoff? — that can come with letting others manage your money.

The hedge fund industry is a particularly virulent strain of money managers. Leading hedge fund managers earn hundreds of millions of dollars, and in some cases, billions of dollars a year. For that you would expect them to generate much higher than average investment performance. In fact, in 2012 hedge funds generated returns after fees — that average 2 percent of the assets under management plus 20 percent of the profits — of 3 percent; whereas the S&P 500 rose 18 percent during that time.

Why do people pay those kinds of fees for such vast underperformance? In a word, people are irrational. For example, it is possible that they first invested in the hedge fund because they got a hot tip from someone who bragged about how great the fund is. And once people make an investment, they are subject to confirmation bias. They lap up information that reinforces their decision and ignore anything that makes the decision look like a bad idea. For example, an investor in a big hedge fund would ignore my argument in the previous paragraph as irrelevant and latch onto data from a different time period that shows how much better hedge funds did than the overall market.

Another form of irrationality is that people can fall victim to sales pitches. There are floors of buildings around the country filled with aspiring young stock brokers who pick up the phone and dial into peoples' homes over and over again, hoping to get someone to pick up who will let them manage their money. Every so often brokers luck into a lonely person with some money who picks up the phone and stays on the line. The brokers befriend the person, using practiced sales pitches to extract their money.

While I do not know what makes stocks go up or down, I have lived through enough stock market bubbles to know that we are probably not in one now — unless, this time is really different. During market bubbles, the media are obsessed with how much money the average citizen is making, whether it is investing in dot-com stocks or buying and refurbishing houses.

But editors of TV networks, newspapers, and magazines are ignoring the biggest stock market boom in the last 70 years that has steadily been enriching those who are invested in it since 2009. Since the S&P 500 bottomed out at 683 in March 2009, stocks have risen an average of 22 percent a year. The second best performance before that over the last 70 years was during the Clinton years, when stocks rose at about a 17 percent annual rate.

Is it too late for you to buy? I don't know, but another winner of 2013's Nobel Prize in economics, Yale Professor, Robert Shiller, has developed a special price/earnings ratio calculation that can help investors think about whether the market is over-valued.

Mr. Shiller's cyclically adjusted price-earnings ratio, which compares the S&P 500 Index with companies' average profits during the past 10 years, ended September 2013 at 23.7, the highest since January 2008 and well below the record of 44 set in December 1999 before the dot-com bubble burst.

Mr. Shiller said in an October 14 press conference, "The stock market is rather highly priced. I worry that it might correct down. I don't think one should view it with alarm. One could well — and probably should, in a diversified portfolio — invest in stocks."

I plan to continue to invest in a stock index mutual fund.

Peter Cohan of Marlboro heads a management consulting and venture capital firm, and teaches business strategy and entrepreneurship at Babson College. His email address is peter@petercohan.com.